Falling Apart
Good Morning! If you hadn’t noticed, TLBS is now arriving in your inbox 30 minutes earlier, at 8:00AM EST. Grab a coffee and take a read. This week’s post discusses the benefit of economic cooperation, and the detriment of isolation. The information here may not be new to you, but I hope the argument brings fresh perspective to a serious and timely topic. As always, thank you for reading.
Game Theory
Game Theory, the study of the strategy between rational actors, involves role-playing games with defined sets of choices and consequences. The most famous game - one that you’ve likely encountered in an economics or sociology class - is The Prisoner’s Dilemma.
Originally developed by Merrill Flood and Melvin Dresher in 1950, The Prisoner’s Dilemma pits two arrested co-conspirators against each other. Each prisoner is given the choice whether to rat on their comrade, in exchange for a lighter sentence. The length of their sentence is determined by the independent actions of both individuals.
If both prisoners rat on each other, they are given a 2-year sentence. If neither of them rat, then they both are given a 1-year sentence. But, if one prisoner rats and the other stays silent then the rat goes free and the silent actor gets a 3-year sentence. The prisoners cannot communicate with each other to develop a strategy.
The options and outcomes are portrayed in a simple payoff matrix.
According to this game, Prisoner A and Prisoner B are each incentivized to rat on each other even though the shortest aggregate prison time is achieved if they both stay silent. The game demonstrates that rational actors may eschew collective cooperation in order to maximize individual outcomes.
But The Prisoner’s Dilemma is bunk. Or, perhaps, The Prisoner’s Dilemma is a stylized academic exercise that runs contrary to the majority of real-world economic scenarios. The problem with the Dilemma lies in the game’s construction. The conclusion is driven by the given assumptions of the game itself rather than a natural bias against cooperation1.
In reality, rational self-interest incentivizes economic cooperation and leads to abundance.
A better game to understand how economics works goes like this.
There are two players. Each player needs food and water to survive. Alone, each player can fetch one jug of water and kill one rabbit. Alternatively, if each individual focuses on just one activity they can improve their efficiency and can either fetch four jugs of water or kill four rabbits.
The optimal outcome is obvious - they divide and conquer. One player hunts rabbits, one fetches water, and they split the pot. Each player ends up with twice as much food and water as they could produce individually, harnessing the efficiency of scale and the productivity of specialization.
Real world economics is not a zero sum game, nor is it limited to two players. Every new person who joins the pool increases aggregate productivity and the yield per person. Critically, each player is motivated by their self interest, not collective altruism. The players don’t need to like each other, they just need to want more food and water. The system hinges on mutual benefit.
But this system is also not foolproof, as it breeds mutual reliance. If one player isn’t willing to trade with the other, then it forces both parties to de-specialize, giving back efficiency and productivity in the process. One party’s willingness to live with less can force the other player to do the same. The second player must also change their strategy to avoid ending up with too much meat and no water. Mutual destruction.
Cooperation leads to a win-win outcome of abundance, isolation results in a lose-lose outcome of scarcity.
Today’s global economy, which has brought the greatest aggregate living standards in human history, is motivated by self-interest and enabled by global cooperation. A breakdown of global cooperation ensures mutual destruction.
War and Peace
For much of the twentieth century, the world was at war. Wars of physical violence, World War I and II, were followed by a Cold War of physical threat, deterrence, proxy conflict and economic competition. The Western and Eastern Blocs collaborated internally, but were isolated from each other economically.
Ultimately, the economic system of mutually beneficial self-interest, capitalism, practiced by the Western Bloc proved far more fruitful and resilient than economic systems ostensibly motivated by collective interest, communism or socialism, practiced by the Eastern Bloc. The fall of the Berlin Wall and collapse of the Soviet Union ended the Cold War and cemented the path for global economic development in the Western template.
For the past thirty years, the world’s great powers have been at peace. Former enemies began to develop trade ties, hunting rabbits and gathering water. Peace allows cooperation and cooperation leads to abundance. Peace breads mutual benefit and mutual reliance.
China, underdeveloped and scarred from poor policy, witnessed an explosion in prosperity and living standards over the past three decades due to both internal reform and global liberalization. The country’s GDP per capita measured in constant PPP adjusted currency has increased twelve-fold, or a 8.5% compounded annual rate since 1990.
Russia’s path was less direct. The economy was far more developed than China in the twentieth century, but had been backsliding long before the collapse of the USSR. Market reform did not immediately reverse an economy in contraction, and indeed the country’s productive capacity continued to shrink until the turn of the century. However, since 2000, Russia’s GDP per capita rose at an annual rate of 3.2% for the next twenty years - far outpacing the growth rates in West.
It is not a coincidence that this period of economic growth coincided with increasing global trade. Rather, it was enabled by global trade (alongside internal reform).
Yet, while growth in living standards and productive capacity is perhaps more obvious in the former Eastern Bloc, the West benefitted greatly as well.
China exports labor via manufactured goods, allowing western consumers cheap products while the West exports technology, advanced equipment, and agricultural products to China. Think of the iPhone - designed in California, manufactured in China - enjoyed by consumers in both.
Russia exports cheap energy, agricultural goods and minerals, enabling higher living standards for the rest of the world, while importing more complex goods that were manufactured in part with the energy Russia supplies.
The tendency to view trade in zero-sum terms misses the mutual benefit of globalization in aggregate terms.
Growing Apart
Yet, while global economic cooperation leads to higher human living standards and abundance in aggregate across the global population, it does not do so equally nor is it beneficial for every single person. Imports may render local industry obsolete. U.S. manufacturers (and their employees) who have been undercut by foreign competition may be much worse off, even if they also enjoy cheaper products.
Relative winners and losers often fall along class lines. In Western countries, capital holders benefit disproportionately while labor suffers. In theory, labor can be repurposed into higher value-added functions over time, but that transition is not always smooth and academic arguments provide little consolation.
These internal tradeoffs and disparities are one of the greatest challenges to manage in an increasingly intertwined global economy. Further, non-economic considerations often take precedent. Concerns around human rights, political ideology, or military competition, may supersede the simple desire for more stuff.
In the first two decades of the post-Cold War era the world was growing ever closer together, but over the past ten years, cracks have emerged.
In 2012, Xi Jinping and Vladimir Putin became heads of state in China and Russia, with more authoritarian and nationalistic tendency than their predecessors. At the same time, the West has become increasingly anxious about the direction of global influence.
In the case of China, the tension centers around economic dominance. China’s ascendance to the second largest economy in the world has transformed it from a resource to a rival in the eyes of the United States. “Tough on China” was a key theme of Donald Trump’s successful election in 2016, and by early 2018 his administration kicked off the modern trade war, imposing tariff on Chinese imports. The Biden administration has largely maintained Trump’s policy on China, which seems to be one of the very few areas of bi-partisan agreement in American politics.
The trade war prompted tit-for-tat retaliation by the Chinese, expanding beyond imports to other areas of tension such as stock listings and disclosure requirements. Diplomatic relations have soured dramatically, and are further inflamed by political hot-buttons including Hong Kong, Taiwan, and human rights abuse.
Meanwhile, Russia’s tension centers on its military aggression. The annexation of Crimea in 2014 was met with international outcry from Western leaders and an array of economic sanctions. Since then, the Kremlin has been taking preemptive steps to insulate itself financially in advance of further more sanctions - selling off its reserves of U.S. Treasuries and preparing operationally to be cut out of the international dollar settlement system, SWIFT.
As international tensions escalated, so did growing domestic discontent, partially due to legitimate concerns around the uneven effects of globalization. A wave of populist political movements fanned out across the globe, including the U.K.’s Brexit vote in 2016, the election of Trump in the U.S., Bolsonaro in Brazil, and Modi in India. At the heart of these movements was the rejection of neoliberal globalization in favor of nationalism.
These were spats, skirmishes, and warning shots, but not declarations of war.
Scarcity
On February 24, 2022, Russia declared war on Ukraine. In response to this unprovoked and unjustifiable act, the West responded with its well-telegraphed promise to declare economic war on Russia. Sanctions led by the United States and European Union were designed to isolate and hobble the country’s economy and force a military retreat.
Over $1 trillion in assets were frozen, Russia was barred from the SWIFT payment system, and the country’s stock market was cut in half, falling 49% over five days, before settling down around 35% from pre-invasion levels. Even after years of preparation for such extreme sanctions, the impact was still enormous.
If Russia struck first with military might, the West swung back with economic might. Overnight, developed countries decided they were no longer willing to trade with one of the world’s largest exporter of energy and hard commodities2.
While the impact was first felt in Russia, Game Theory ensures the fallout would not be one-sided. As economic cooperation leads to mutual benefit, its reversal ensures mutual destruction. Waging economic war trades abundance for scarcity.
Before the invasion, Russia caught rabbits and Europe fetched water. When the two players decided they were no longer was willing to pool resources, it guaranteed that Russia would be short of water, and that Europe would be short of food.
Flows from Nord Stream 1, a key natural gas pipeline into Europe, slowed over the summer and finally came to a halt last week. Moscow declared that the pipeline would remain shut down until the “collective West” lifts its crippling sanctions imposed after the invasion of Ukraine. This announcement was no surprise, but rather was a guaranteed counterpunch of economic warfare.
It is still early days. We can’t say for sure how damaging Europe’s energy crisis turns out to be (though it remains the subject of vast speculation), but early signs are not good. Natural gas and power markets have already been thrown into chaos with unpredictable financial consequences. It is likely that energy rationing of some form will be required over the coming winter. Europe’s productivity capacity will surely contract as resources will be diverted towards securing new energy supply.
Today there is no shortage of hot takes about which side is “winning” the war. This framing is simply wrong and backwards. Nobody is winning the war.
War is death, war is destruction, war is scarcity.
The Brink
I was born in 1991, the year that the Soviet Union collapsed. During my lifetime, the global superpowers have been at peace, growing closer together. In the same time, humans have flourished. There are a billion fewer people living in poverty despite global population increasing dramatically. Living standards and life expectancy have improved across the globe. The vast majority of the global population is more prosperous and productive than ever, even if the benefits are not evenly distributed. At the center of this abundance has been increasing global interconnectivity and cooperation.
Now, for the first time I can remember, the world is tilting away from each other as economic rivalry, domestic unrest, and military aggression take precedent over collaboration and prosperity.
It is easy to be captured by the drums of war, to declare allegiances and hate your enemy. It is easy to watch from afar as a form of gladiatorial entertainment, and pontificate on who has the leverage, who is winning. It is even easier when the blessings of abundance have been taken for granted.
We must resist this urge. Already, Russia’s invasion of Ukraine has brought far reaching human and economic consequences with no obvious path to resolution. Rattling sabers in the Pacific while ratcheting diplomatic rhetoric only increases risk of a broader and more devastating conflict.
There are no winners in a physical or economic war, only losers. There may be times when conflict is unavoidable, but this makes it no less tragic. Cooperation brings abundance. War is mutual destruction.
In fact, research has demonstrated that there is a strong bias towards cooperation in most human systems. This should be unsurprising, as cooperation is essential to our economy and human civilization.
Though sanctions included a carveout for certain energy purchases.
amazing stuff. thanks a ton for your insight!
All your writing is crystal clear and does a great job to recalibrate to a big picture amidst data and noise. Thank You